Fiscal Policy and Monetary Policy (Part Two)

Fiscal Policy and Monetary Policy (Part 2) – Pan Deng’s Notes on Macroeconomics

Money Economy Under Sticky Prices

aggregate supply curve

A supply curve at the micro level is not the same thing as a supply or demand curve at the macro level

• The horizontal axis of the microcosm is the quantity, and the vertical axis is the price, and this price is the commodity price denominated in currency. If we are discussing the real economy and no currency is introduced, then the price represents the relative price denominated in other commodities
• If at the macro level, it is simply summing up all the micro supply curves, then the price summation will be difficult to achieve, because it is difficult to unify the relative price into a comparable measure. When all are priced in gold, the relative price of gold itself The price is 1; the price of the macro aggregate supply curve is the "overall price level" denominated in currency, not the "relative price" between commodities

In the classical dichotomy, money does not affect any real variable in the economy at all, only the price level.

In the real world, by observing the changes in the real growth rate of GDP and the level of inflation, it can be seen that the aggregate supply curve is obviously not vertical

The slope of the aggregate supply curve and price stickiness

Whether the aggregate supply curve is vertical or not means whether the currency shock has an impact on the real economy

• Vertical aggregate supply curve : If the price is flexible, the change in the quantity of money is completely absorbed by the price change, so it has no effect on the real economy
  • Classical Dichotomy: Money has absolutely no effect on the real economy
    • "Money is just a veil over the real economy"
    • Neutrality of money, super-neutrality of money
  • Left undisturbed, the economy will naturally operate at the “natural level of output”—also known as the “potential output”
• Sloped aggregate supply curve : If there is nominal rigidity (nominal rigidity), the price cannot change flexibly to fully absorb the shock of the currency, and the currency will have an impact on the real economy
  • Sticky price (sticky price): price adjustment cycle, menu cost (menu cost)
  • Sticky wages: Keynes' idea

The disappearance of the Phillips curve

The aggregate supply curve is a form of the Phillips curve

Convert the output gap to the unemployment rate to get the Phillips curve

Reasons for the disappearance of the Phillips curve

• When the government does not realize that it can lower the unemployment rate by increasing inflation, when the overall price level in the society rises, indicating strong social demand and business expansion, the unemployment rate will naturally decline, and the Phillips curve will slope downward at this time;
• And when the government consciously adjusts inflation to reduce unemployment, on the one hand, the government’s artificial increase in inflation will lead to inflation, and the expansion of enterprises will also lead to inflation, which leads to a higher level of inflation and makes the Phillips curve shift up. ; When the government tries to reduce inflation, as demand slows down, companies reduce output, the price level falls, unemployment rises, inflation falls further, and the Phillips curve moves down again;

Indicated in the figure is

From the disappearance of the Phillips curve, two very important conclusions can be seen

1. Expectations play a very important role in the operation of the economy.
2. Monetary policy can only affect the real economy in the short term. How long the short term is depends on how long the monetary policy can "fool" the public. There is a gap between policy operations. In other words, the impact of monetary policy on the real economy comes from "exceeding expectations."

In the language of the aggregate supply curve, the aggregate supply curve is upward sloping in the short run but vertical in the long run ;

Only unexpected monetary shocks have an impact on the real economy (anticipated monetary shocks have no impact on the real economy)

• The effect of money on the real economy depends on inflation expectations
  • When there is price stickiness, firms set current prices based on expectations of future prices (inflation expectations) - because the currently set price will remain in the future for a period of time
  • Anticipated monetary shocks are fully absorbed by prices and thus do not affect the real economy
  • Inflation expectations are affected by current inflation conditions and monetary policy expectations
• The impact of monetary policy on the real economy only exists in the "short term" (the short term is not the long term)
  • Only Unexpected Currency Shocks Affect the Real Economy
  • Inflation expectations will be adjusted according to the operation of monetary policy - more currency issuance will push up inflation expectations
  • The "short term" is a few quarters - after a currency shock occurs, expectations and prices will adjust in place within a few quarters to absorb the currency shock
  • If monetary policy wants to continue to stimulate real economic growth, monetary growth needs to continue to exceed expectations - which will inevitably lead to accelerated rises in currency issuance and inflation until they get out of control

Monetary policy is the art of regulating expectations

"His second goal showed the power of anticipation in MMT. Maradona ran the ball for 60 yards from the second half, past five defenders, and finally fired the ball into England. The most amazing thing is that Maradona almost ran in a straight line. How can you run a straight line to pass 5 defenders? The answer is that the British defenders are following their next step against Maradona They react to expectations of action. Since they expect Maradona to move left or right, Maradona can run straight past them... Monetary policy has a similar effect. Market interest rates based on what the central bank expects to do next Act to react."
- Mervyn King, 2005

Monetary Policy's "Dynamic Inconsistency"

The dual objectives of monetary policy will bring about dynamic inconsistencies

• The government's dual objectives: promoting economic growth (employment) and achieving lower inflation
• Before people's inflation expectations are formed: the government has an incentive to let people form low inflation expectations
• After the public's inflation expectations are formed: the government has the incentive to deviate from its previous commitments and promote economic growth by creating higher-than-expected inflation
• The public will expect the government to deviate from its promises, thus creating high inflation in the first place
• As a result, economic growth is not being stimulated, and inflation is unnecessarily high

If the government can credibly commit to low inflation and stick to it, economic growth will be unstimulated and inflation will be low, better than in a state of inconsistent dynamics

Ways to Overcome Inconsistent Monetary Policy Dynamics

• Implement inflation targeting
• Increase central bank independence (central bank independence) - pay attention to distinguish it from currency dominance
• Choose a central banker with a reputation for aversion to inflation

Coordination of Fiscal Policy and Monetary Policy

Fiscal dominance vs. monetary dominance

Fiscal dominance
$$discountedfiscalspendingand=discountedfiscalrevenueand+SeigniorageDiscountedand$$
Currency DominanceFiscal Expenditure Discounted Sum = Fiscal Revenue Discounted and Fiscal Expenditure Discounted Sum = Fiscal Revenue Discounted$$Sum$$
$$discountedfiscalspendingand=discountedfiscalrevenueand$$

China's "Fiscal Dominance" in the 1980s

"According to the current estimated figures, in 1984, the total national fiscal revenue was 146.5 billion yuan, and the total national fiscal expenditure was 151.5 billion yuan. The revenue and expenditure were balanced, and the fiscal deficit was 5 billion yuan. The fiscal deficit for this year is pending the compilation of final accounts. Afterwards, it is prepared to overdraft to the People's Bank of China to make up for it."
—— "Report on the Implementation of the State Budget in 1984 and the Draft State Budget in 1985"

"Fiscal deficits and credit balances are closely related to currency issuance. It is not terrible to have some fiscal deficits and credit balances in certain years during the economic growth process, but if the amount is too large and lasts for too long, it will lead to currency issuance. Excessive issuance has caused severe inflation, caused a sharp rise in prices, and caused chaos in economic life."
—— "Report on the Work of the Government in 1987"

The PBOC Law establishes a currency-led framework

The People's Bank of China shall not overdraft the government's finances, and shall not directly subscribe or underwrite treasury bonds and other government bonds.
——Article 29 of the Law of the People's Republic of China on the People's Bank of China

hyperinflation always comes from fiscal failure

• The fiscal gap needs a large amount of seigniorage to make up for, so the rapid increase of currency leads to high inflation
• High inflation pushes up inflation expectations, which leads to a rapid decline in the actual balance of currency and reduces the real revenue of government seigniorage (inflation increases reduce the purchasing power of seigniorage)
• In order to ensure actual seigniorage revenue (the nominal amount of newly issued currency divided by the price level), the speed of government currency issuance must continue to exceed private inflation expectations, resulting in accelerated inflation and eventually hyperinflation

Therefore, during the period from the 1980s to the early 1990s, when there were more fiscal expenditures (often because the government did more investment projects), money growth would get out of control, leading to high inflation. The two high inflations after China's reform and opening up occurred during this period, which left people with a deep memory of "snatching buying style".

Since hyperinflation comes from the transmission of fiscal problems to monetary policy, fixing fiscal problems, or at least stopping the process of monetizing fiscal deficits, is the way to end hyperinflation. The story of Jeffrey Sachs in Bolivia is a good example. In 1985, Jeffrey Sachs, who was teaching at Harvard University at the time, was invited to Bolivia to help the Bolivian government deal with hyperinflation that was as high as 24,000% at the time. Sachs found that the price of oil sold by Bolivia's state-owned oil company obviously could not keep up with the soaring price level. This has driven down the price of oil relative to other commodities, reducing the Bolivian government's real revenue from oil sales to very low levels. Since Bolivia's fiscal revenue is largely dependent on oil revenue, this has led to a large-scale fiscal deficit in Bolivia, which can only be made up by issuing additional currency, resulting in higher inflation. After learning about this situation, Sachs proposed to the Bolivian government to substantially increase the price of oil, supplemented by other fiscal consolidation measures. At first, Bolivian officials were appalled by Sachs' proposal. It was difficult to understand how a sharp increase in oil prices could be used to control soaring commodity prices. But then government officials were persuaded and put it into action. Bolivia's hyperinflation ended in a week, making Sachs famous at the age of 31. "The package of economic reforms advocated by Sachs in Bolivia is called shock therapy, which has also been widely used in the transformation of the Soviet Union and Eastern European countries.

China turns to currency-led change

The main reasons for the obvious synchronization between China's fiscal deficit and credit are: the coordination of fiscal policy and monetary policy, and the relaxation and contraction of fiscal policy and monetary policy often occur simultaneously;